GUIDANCE NOTE
ON MANAGEMENT OF OPERATIONAL RISK
RESERVE BANK OF INDIA
DEPARTMENT OF BANKING OPERATIONSAND DEVELOPMENTCENTRAL OFFICE
MUMBAI
INDEX
GUIDANCE NOTE ON OPERATIONAL RISK MANAGEMENT
Subject
1 Executive Summary
2 Background
3 Organisational set-up and Key responsibilities forOperational Risk
4 Policy requirements and strategic approach
5 Identification and Assessment of Operational Risk
6 Monitoring of Operational Risk
7 Controls / Mitigation of Operational Risk
8 Independent evaluation of Operational Risk Management
9 Capital allocation for Operational Risk
Annex 1 Indicative role of Organisational arm of risk managementstructure
Annex 2 Mapping of Business Lines
Annex 3 Loss Event type classification
Annex 4 Advanced Measurement Methodologies
PREFACE
As a step towards enhancing and fine-tuning the risk management practices as
also to serve as a benchmark to banks, the Reserve Bank had issued Guidance
Notes on management of credit risk and market risk in October 2002. The
guidance notes are placed on our web-site for wider dissemination.
The New Capital Adequacy Framework requires banks to hold capital explicitly
towards operational risk. In view of this as also the felt need for a similar guidance
note on management of operational risk, this Guidance Note has been prepared.
This guidance note is an outline of a set of sound principles for effective
management and supervision of operational risk by banks.
Banks may use the Guidance Note for upgrading their operational risk
management system. The design and architecture for management of operational
risk should be oriented towards banks' own requirements dictated by the size and
complexity of business, risk philosophy, market perception and the expected level
of capital. The exact approach may, therefore, differ from bank to bank. Hence the
systems, procedures and tools prescribed in this Guidance Note are indicative.
Executive Summary
Growing number of high-profile operational loss events worldwide have led banks
and supervisors to increasingly view operational risk management as an integral
part of the risk management activity. Management of specific operational risks is
not a new practice; it has always been important for banks to try to prevent fraud,
maintain the integrity of internal controls, reduce errors in transaction processing,
and so on. However, what is relatively new is the view of operational risk
management as a comprehensive practice comparable to the management of
credit and market risk. 'Management' of operational risk is taken to mean the
'identification, assessment, and / or measurement, monitoring and control /
mitigation' of this risk.
2. The Guidance Note is structured into 8 chapters. This Guidance Note defines
Operational Risk and its likely manifestation in Chapter 1. In order to create an
enabling organisational culture and placing high priority on effective operational
risk management and implementation of risk management processes, Chapter 2
gives a typical outline of the organisational set-up in the bank, together with the
responsibilities of the Board and Senior Management. Chapter 3 deals with the
policy requirements and strategic approach to Operational Risk Management.
The policies and procedures should outline all aspects of the bank's Operational
Risk Management Framework. Chapter 4 deals with issues of identification and
assessment of Operational Risk. Chapter 5 deals with monitoring of Operational
Risk. This chapter has put in one place the business lines that a bank needs to
identify and the principles underlying mapping of these business lines. Details of
effective control / mitigation of Operational Risk are dealt in Chapter 6. Internal
audit and its scope for an independent evaluation of the Operational Risk
Management function are dealt under Chapter 7. Although the Guidance Note is
an outline of sound principles for effective management and supervision of
operational risk by banks, capital allocation for Operational Risk based on Basic
Indicator Approach is outlined in Chapter 8.
3. The exact approach for operational risk management chosen by banks will
depend on a range of factors. Despite these differences, clear strategies and
oversight by the Board of Directors and senior management, a strong operational
risk management culture, effective internal control and reporting, contingency
planning are crucial elements for an effective operational risk management
framework. Initiatives required to be taken by banks in this regard will include the
following:
o The Board of Directors is primarily responsible for ensuring effective
management of the operational risks in banks. The bank's Board of
Directors has the ultimate responsibility for ensuring that the senior
management establishes and maintains an adequate and effective system
of internal controls.
o Operational risk management should be identified and introduced as an
independent risk management function across the entire bank/ banking
group.
o The senior management should have clear responsibilities for
implementing operational risk management as approved by the Board of
Directors.
o The board of directors and senior management are responsible for
creating an awareness of Operational Risks and establishing a culture
within the bank that emphasises and demonstrates to all the levels of
personnel the importance of Operational Risk.
o The direction for effective operational risk management should be
embedded in the policies and procedures that clearly describe the key
elements for identifying, assessing, monitoring and controlling / mitigating
operational risk.
o The internal audit function assists the senior management and the Board
by independently reviewing application and effectiveness of operational
risk management procedures and practices approved by the Board/ senior
management.
o The New Capital Adequacy Framework has put forward various options for
calculating operational risk capital charge in a "continuum" of increasing
sophistication and risk sensitivity and increasing complexity. Despite the
fact that banks may adopt any one of these options for computing capital
charge, it is intended that they will benchmark their operational risk
management systems with the guidance provided in this Note and aim to
move towards more sophisticated approaches.
Chapter 1
Background
1.1 Financial institutions are in the business of risk management and hence are
incentivised to develop sophisticated risk management systems. The basic
components of a risk management system are identifying the risks the entity is
exposed to, assessing their magnitude, monitoring them, controlling or mitigating
them using a variety of procedures, and setting aside capital for potential losses
(including expected losses and unexpected losses)*
1.2. Deregulation and globalisation of financial services, together with the growing
sophistication of financial technology, are making the activities of banks and thus
their profiles more complex. Evolving banking practices suggest that risks other
than credit risks and market risks can be substantial. Examples of these new and
growing risks faced by banks include:
� Highly Automated Technology - If not properly controlled, the greater useof more highly automated technology has the potential to transform risksfrom manual processing errors to system failure risks, as greater relianceis placed on integrated systems.
� Emergence of E- Commerce – Growth of e-commerce brings with itpotential risks (e.g. internal and external fraud and system securitiesissues)
� Emergence of banks acting as very large volume service providerscreates the need for continual maintenance of high-grade internal controlsand back-up systems.
� Outsourcing – growing use of outsourcing arrangements and theparticipation in clearing and settlement systems can mitigate some risksbut can also present significant other risks to banks.
� Large-scale acquisitions, mergers, de-mergers and consolidations test theviability of new or newly integrated systems.
� Banks may engage in risk mitigation techniques (e.g. collateral,derivatives, netting arrangements and asset securitisations) to optimisetheir exposure to market risk and credit risk, but which in turn mayproduce other forms of risk (eg. legal risk).
* Para 669 (b) of the International Convergence of Capital Measurement & Capital Standards – ARevised Framework, June 2004.
Definition
1.3. Definition of operational risk has evolved rapidly over the past few years. At
first, it was commonly defined as every type of unquantifiable risk faced by a
bank. However, further analysis has refined the definition considerably.
Operational risk has been defined by the Basel Committee on Banking
Supervision1 as the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. This definition
includes legal risk, but excludes strategic and reputational risk. This
definition is based on the underlying causes of operational risk. It seeks to identify
why a loss happened and at the broadest level includes the breakdown by four
causes: people, processes, systems and external factors.
Likely forms of manifestation of operational risk
1.4. A clear appreciation and understanding by banks of what is meant by
operational risk is critical to the effective management and control of this risk
category. It is also important to consider the full range of material operational risks
facing the bank and capture all significant causes of severe operational losses.
Operational risk is pervasive, complex and dynamic. Unlike market and credit risk,
which tend to be in specific areas of business, operational risk is inherent in all
business processes. Operational risk may manifest in a variety of ways in the
banking industry. The examples of operational risks listed at paragraph 1.2 above
can be considered as illustrative.
1.5. The Basel Committee has identified2 the following types of operational risk
events as having the potential to result in substantial losses:
• Internal fraud. For example, intentional misreporting of positions, employeetheft, and insider trading on an employee’s own account.
• External fraud. For example, robbery, forgery, cheque kiting, and damagefrom computer hacking.
• Employment practices and workplace safety. For example, workerscompensation claims, violation of employee health and safety rules,organised labour activities, discrimination claims, and general liability.
1 ibid, June 20042 ibid, June 2004- Annex 6
• Clients, products and business practices. For example, fiduciarybreaches, misuse of confidential customer information, improper tradingactivities on the bank’s account, money laundering, and sale of unauthorisedproducts.
• Damage to physical assets. For example, terrorism, vandalism,earthquakes, fires and floods.
• Business disruption and system failures. For example, hardware andsoftware failures, telecommunication problems, and utility outages.
• Execution, delivery and process management. For example: data entryerrors, collateral management failures, incomplete legal documentation, andunauthorized access given to client accounts, non-client counterpartymisperformance, and vendor disputes.
Chapter 2
Organisational Set-up and Key Responsibilities for Operational Risk Management
Relevance of Operational risk function
2.1 Growing number of high-profile operational loss events worldwide have led
banks and supervisors to increasingly view operational risk management as an
integral part of risk management activity. Management of specific operational
risks is not a new practice; it has always been important for banks to try to
prevent fraud, maintain the integrity of internal controls, reduce errors in
transaction processing, and so on. However, what is relatively new is the view
that operational risk management is a comprehensive practice comparable to the
management of credit and market risks.
2.2 Operational Risk differs from other banking risks in that it is typically not
directly taken in return for an expected reward but is implicit in the ordinary
course of corporate activity and has the potential to affect the risk management
process. However, it is recognised that in some business lines with minimal credit
or market risks, the decision to incur operational risk, or compete based on the
perceived ability to manage and effectively price this risk, is an integral part of a
bank's risk / reward calculus. At the same time, failure to properly manage
operational risk can result in a misstatement of an institution's risk profile and
expose the institution to significant losses. 'Management' of operational risk is
taken to mean the 'identification, assessment and / or measurement,
monitoring and control / mitigation' of this risk.
Organizational set up and culture
2.3 Operational risk is intrinsic to a bank and should hence be an important
component of its enterprise wide risk management systems. The Board and
senior management should create an enabling organizational culture placing high
priority on effective operational risk management and adherence to sound
operating procedures. Successful implementation of risk management process
has to emanate from the top management with the demonstration of strong
commitment to integrate the same into the basic operations and strategic decision
making processes. Therefore, Board and senior management should promote an
organizational culture for management of operational risk.
2.4 It is recognised that the approach for operational risk management that
may be chosen by an individual bank will depend on a range of factors, including
size and sophistication, nature and complexity of its activities. However, despite
these differences, clear strategies and oversight by the Board of Directors and
senior management; a strong operational risk culture, i.e., the combined set of
individual and corporate values, attitudes, competencies and behaviour that
determine a bank's commitment to and style of operational risk management;
internal control culture (including clear lines of responsibility and segregation of
duties); effective internal reporting; and contingency planning are all crucial
elements of an effective operational risk management framework.
2.5 Ideally, the organizational set-up for operational risk management should
include the following:
� Board of Directors
� Risk Management Committee of the Board
� Operational Risk Management Committee
� Operational Risk Management Department
� Operational Risk Managers
� Support Group for operational risk management
2.6 A typical organisation chart for supporting operational risk management
function could be as under:
It has to be ensured that each type of major risk viz. Credit Risk, Market Risk and
Operational Risk, is managed as an independent function. Hence, banks should
have corresponding risk management committees, which are assigned the
specific responsibilities. Banks may structure the risk management department(s)
as appropriate without compromising on the above principles.
BOARD OF DIRECTORS(Decide overall risk management policy and strategy)
RISK MANAGEMENT COMMITTEEBoard Sub-Committee including CEO and Heads of Credit,Market and Operational Risk Management Committees(Policy and Strategy for Integrated Risk Management)
CREDIT RISKMANAGEMENTCOMMITTEE
MARKET RISKMANAGEMENTCOMMITTEE
OPERATIONAL RISKMANAGEMENTCOMMITTEE
Chief Risk Officer
Credit RiskManagementDepartment
Operational RiskManagement
Department
Market RiskManagementDepartment
Business Operational
Risk ManagerOperational RiskManagementSpecialist
Department Heads
Board Responsibilities:
2.7 Board of Directors of a bank is primarily responsible for ensuring effective
management of operational risks. The Board would include Committee of the
Board to which the Board may delegate specific operational risk management
responsibilities:
� The Board of Directors should be aware of the major aspects of the bank’soperational risks as a distinct risk category that should be managed, and itshould approve an appropriate operational risk management framework forthe bank and review it periodically.
� The Board of Directors should provide senior management with clearguidance and direction.
� The Framework should be based on appropriate definition of operationalrisk which clearly articulates what constitutes operational risk in the bankand covers the bank’s appetite and tolerance for operational risk. Theframework should also articulate the key processes the bank needs tohave in place to manage operational risk.
� The Board of Directors should be responsible for establishing amanagement structure capable of implementing the bank's operational riskmanagement framework. Since a significant aspect of managingoperational risk relates to the establishment of strong internal controls, it isparticularly important that the Board establishes clear lines of managementresponsibility, accountability and reporting. In addition, there should beseparation of responsibilities and reporting lines between operational riskcontrol functions, business lines and support functions in order to avoidconflicts of interest.
� Board shall review the framework regularly to ensure that the bank ismanaging the operational risks arising from external market changes andother environmental factors, as well as those operational risks associatedwith new products, activities or systems. This review process should alsoaim to assess industry best practice in operational risk managementappropriate for the bank’s activities, systems and processes. If necessary,the Board should ensure that the operational risk management frameworkis revised in light of this analysis, so that material operational risks arecaptured within.
� Board should ensure that the bank has in place adequate internal auditcoverage to satisfy itself that policies and procedures have beenimplemented effectively. The operational risk management frameworkshould be subjected to an effective and comprehensive internal audit byoperationally independent, appropriately trained and competent staff. Theinternal audit function should not directly involved in the operational riskmanagement process. Though, in smaller banks, the internal audit functionmay be responsible for developing the operational risk management
programme, responsibility for day-to-day operational risk managementshould be transferred elsewhere.
Senior Management Responsibilities
2.8 Senior management should have responsibility for implementing the
operational risk management framework approved by the Board of Directors. The
framework should be consistently implemented throughout the whole banking
organisation, and all levels of staff should understand their responsibilities with
respect to operational risk management. The additional responsibilities that
devolve on the senior management include the following:
� To translate operational risk management framework established by theBoard of Directors into specific policies, processes and procedures thatcan be implemented and verified within the different business units.
� To clearly assign authority, responsibility and reporting relationships toencourage and maintain this accountability, and ensure that the necessaryresources are available to manage operational risk effectively.
� To assess the appropriateness of the management oversight process inlight of the risks inherent in a business unit’s policy.
� To ensure bank’s activities are conducted by qualified staff with thenecessary experience, technical capabilities and access to resources, andthat staff responsible for monitoring and enforcing compliance with theinstitution’s risk policy have authority independent from the units theyoversee.
� To ensure that the bank’s operational risk management policy has beenclearly communicated to staff at all levels in the units that incur materialoperational risk.
� To ensure that staff responsible for managing operational riskcommunicate effectively with staff responsible for managing credit, market,and other risks as well as with those in the bank who are responsible forthe procurement of external services such as insurance purchasing andoutsourcing agreements. Failure to do so could result in significant gaps oroverlaps in a bank’s overall risk management programme.
� To give particular attention to the quality of documentation controls andtransaction-handling practices. Policies, processes and procedures relatedto advanced technologies supporting high transaction volumes, inparticular, should be well documented and disseminated to all relevantpersonnel.
� To ensure that the bank's HR policies are consistent with its appetite forrisk and are not aligned to rewarding staff who deviate from policies.
2.9 The broad indicative role of each organisational arm of the risk
management structure both at the corporate level and at the functional level is
indicated in brief in Annex 1. These can be customised to the actual requirements
of each bank depending upon the size, risk profile, risk appetite and level of
sophistication.
Chapter 3
Policy Requirements and Strategic Approach
3.1 The operational risk management framework provides the strategic
direction and ensures that an effective operational risk management and
measurement process is adopted throughout the institution. Each institution's
operational risk profile is unique and requires a tailored risk management
approach appropriate for the scale and materiality of the risk present, and the size
of the institution. There is no single framework that would suit every institution;
different approaches will be needed for different institutions. In fact, many
operational risk management techniques continue to evolve rapidly to keep pace
with new technologies, business models and applications. Operation risk is more
a risk management than measurement issue. The key elements in the Operational
Risk Management process include –
• Appropriate policies and procedures;
• Efforts to identify and measure operational risk
• Effective monitoring and reporting
• A sound system of internal controls; and
• Appropriate testing and verification of the Operational RiskFramework.
Policy Requirement
3.2 Each bank must have policies and procedures that clearly describe the
major elements of the Operational Risk Management framework including
identifying, assessing, monitoring and controlling / mitigating operational risk.
3.3 Operational Risk Management policies, processes, and procedures should
be documented and communicated to appropriate staff i.e., the personnel at all
levels in units that incur material operational risks. The policies and procedures
should outline all aspects of the institution's Operational Risk Management
framework, including: -
• The roles and responsibilities of the independent bank-wide Operational RiskManagement function and line of business management.
• A definition for operational risk, including the loss event types that will bemonitored.
• The capture and use of internal and external operational risk loss dataincluding data potential events (including the use of Scenario analysis).
• The development and incorporation of business environment and internalcontrol factor assessments into the operational risk framework.
• A description of the internally derived analytical framework that quantifies theoperational risk exposure of the institution.
• A discussion of qualitative factors and risk mitigants and how they areincorporated into the operational risk framework.
• A discussion of the testing and verification processes and procedures.
• A discussion of other factors that affect the measurement of operational risk.
• Provisions for the review and approval of significant policy and proceduralexceptions.
• Regular reporting of critical risk issues facing the banks and itscontrol/mitigations to senior management and Board.
• Top-level reviews of the bank's progress towards the stated objectives.
• Checking for compliance with management controls.
• Provisions for review, treatment and resolution of non-compliance issues.
• A system of documented approvals and authorisations to ensureaccountability at an appropriate level of management.
• Define the risk tolerance level for the bank, break it down to appropriate sub-limits and prescribe reporting levels and breach of limits.
• Indicate the process to be adopted for immediate corrective action.
3.4 Given the vast advantages associated with effective Operational Risk
Management, it is imperative that the strategic approach of the risk management
function should be oriented towards:
• An emphasis on minimising and eventually eliminating losses and customerdissatisfaction due to failures in processes.
• Focus on flaws in products and their design that can expose the institution tolosses due to fraud etc.
• Align business structures and incentive systems to minimize conflicts betweenemployees and the institution.
• Analyze the impact of failures in technology / systems and develop mitigants tominimize the impact.
• Develop plans for external shocks that can adversely impact the continuity inthe institution’s operations.
3.5 The institution can decide upon the mitigants for minimizing operational risks
rationally, by looking at the costs of putting in mitigants as against the benefit of
reducing the operational losses.
Chapter 4
Identification and Assessment of Operational Risk
4.1 In the past, banks relied almost exclusively upon internal control
mechanisms within business lines, supplemented by the audit function, to manage
operational risk. While these remain important, there is need to adopt specific
structures and processes aimed at managing operational risk. Several recent
cases demonstrate that inadequate internal controls can lead to significant losses
for banks. The types of control break-downs may be grouped into five categories:
� Lack of Control Culture - Management’s inattention and laxity in controlculture, insufficient guidance and lack of clear management accountability.
� Inadequate recognition and assessment of the risk of certain bankingactivities, whether on-or-off-balance sheet. Failure to recognise andassess the risks of new products and activities or update the riskassessment when significant changes occur in business conditions orenvironment. Many recent cases highlight the fact that control systemsthat function well for traditional or simple products are unable to handlemore sophisticated or complex products.
� Absence/failure of key control structures and activities, such assegregation of duties, approvals, verifications, reconciliations and reviewsof operating performance.
� Inadequate communication of information between levels ofmanagement within the bank – upward, downward or cross-functional.
� Inadequate / ineffective audit/monitoring programs.
4.2 Managing Operational Risk is emerging as an important feature of sound
risk management practice in modern financial markets in the wake of phenomenal
increase in volume of transactions, high degree of structural changes and
complex technological support systems. Some of the guiding principles for banks
to mange operational risks are identification, assessment, monitoring and control
of these risks. These principles are dealt in detail below:
Identification of operational risk
4.3 Banks should identify and assess the operational risk inherent in all
material products, activities, processes and systems. Banks should also ensure
that before new products, activities, processes and systems are introduced or
undertaken, the operational risk inherent in them is identified clearly and
subjected to adequate assessment procedures.
4.4 Risk identification is paramount for the subsequent development of a
viable operational risk monitoring and control system. Effective risk identification
should consider both internal factors (such as the bank’s structure, the nature of
the bank’s activities, the quality of the bank’s human resources, organisational
changes and employee turnover) and external factors (such as changes in the
industry and technological advances) that could adversely affect the achievement
of the bank’s objectives.
4.5 The first step towards identifying risk events is to list out all the activities
that are susceptible to operational risk. Usually this is carried out at several
stages. To begin with, we can list:
• The main business groups viz. corporate finance, trading and sales,
retail banking, commercial banking, payment and settlement, agency
services, asset management, and retail brokerage.
• The analysis can be further carried out at the level of the product
teams in these business groups, e.g. transaction banking, trade
finance, general banking, cash management and securities markets.
• Thereafter the product offered within these business groups by each
product team can be analysed, e.g. import bills, letter of credit, bank
guarantee under trade finance.
4.6 After the products are listed, the various operational risk events associated
with these products are recorded. An operational risk event is an incident/
experience that has caused or has the potential to cause material loss to the bank
either directly or indirectly with other incidents. Risk events are associated with
the people, process and technology involved with the product. They can be
recognized by:
(i) Experience - The event has occurred in the past;(ii) Judgment - Business logic suggests that the bank is exposed to a risk
event;
(iii) Intuition - Events where appropriate measures saved the institution inthe nick of time;
(iv) Linked Events - This event resulted in a loss resulting from other risktype (credit, market etc.);
(v) Regulatory requirement – regulator requires recognition of specifiedevents.
4.7 These risk events can be catalogued under the last tier for each of the
products.
Assessment of Operational Risk
4.8 In addition to identifying the risk events, banks should assess their
vulnerability to these risk events. Effective risk assessment allows a bank to
better understand its risk profile and most effectively target risk management
resources. Amongst the possible tools that may be used by banks for assessing
operational risk are:
� Self Risk Assessment: A bank assesses its operations and activitiesagainst a menu of potential operational risk vulnerabilities. This process isinternally driven and often incorporates checklists and/or workshops toidentify the strengths and weaknesses of the operational risk environment.Scorecards, for example, provide a means of translating qualitativeassessments into quantitative metrics that give a relative ranking ofdifferent types of operational risk exposures. Some scores may relate torisks unique to a specific business line while others may rank risks that cutacross business lines. Scores may address inherent risks, as well as thecontrols to mitigate them.
� Risk Mapping: In this process, various business units, organisationalfunctions or process flows are mapped by risk type. This exercise canreveal areas of weakness and help prioritise subsequent managementaction.
� Key Risk Indicators: Key risk indicators are statistics and/or metrics, oftenfinancial, which can provide insight into a bank’s risk position. Theseindicators should be reviewed on a periodic basis (such as monthly orquarterly) to alert banks to changes that may be indicative of risk concerns.Such indicators may include the number of failed trades, staff turnoverrates and the frequency and/or severity of errors and omissions.
Measurement:
4.9 A key component of risk management is measuring the size and scope of
the bank’s risk exposures. As yet, however, there is no clearly established, single
way to measure operational risk on a bank-wide basis. Banks may develop risk
assessment techniques that are appropriate to the size and complexities of their
portfolio, their resources and data availability. A good assessment model must
cover certain standard features. An example is the “matrix” approach in which
losses are categorized according to the type of event and the business line in
which the event occurred. Banks may quantify their exposure to operational risk
using a variety of approaches. For example, data on a bank’s historical loss
experience could provide meaningful information for assessing the bank’s
exposure to operational risk and developing a policy to mitigate/control the risk.
An effective way of making good use of this information is to establish a
framework for systematically tracking and recording the frequency and severity of
each loss event along with other relevant information on individual loss events. In
this way, a bank can hope to identify events which have the most impact across
the entire bank and business practices which are most susceptible to operational
risk. Once loss events and actual losses are defined, a bank can analyze and
perhaps even model their occurrence. Doing so requires constructing databases
for monitoring such losses and creating risk indicators that summarize these data.
Examples of such indicators are the number of failed transactions over a period
of time and the frequency of staff turnover within a division.
4.10 Every risk event in the risk matrix is then classified according to its
frequency and severity. By frequency, the reference is to the number/ potential
number (proportion) of error events that the product type / risk type point is
exposed to. By severity, the reference is to the loss amount/ potential loss
amount that the operational risk event is exposed to when the risk event
materializes. The classification can be on any predefined scale (say 1-10, Low,
Medium, High etc.). All risk events will thus be under one of the four categories,
namely high frequency-high severity, high frequency-low severity, low frequency-
high severity, low frequency-low severity in the decreasing order of the risk
exposure.
4.11 Potential losses can be categorized broadly as arising from “high
frequency, low severity” (HFLS) events, such as minor accounting errors or bank
teller mistakes, and “low frequency, high severity” (LFHS) events, such as
terrorist attacks or major fraud. Data on losses arising from HFLS events are
generally available from a bank’s internal auditing systems. Hence, modeling and
budgeting these expected future losses due to operational risk potentially could
be done very accurately. However, LFHS events are uncommon and thus limit a
single bank from having sufficient data for modeling purposes. Scenario analysis
can be used for filling up scarce data. Scenarios can be treated as potential future
events which need to be captured in terms of their potential frequency and
potential loss severity. Scenarios should be generated for all material operational
risks faced by all the organizational units of the bank. An assessment of the
generated scenarios is carried out by the business experts based on the
information such as historical losses, key risk indicators, insurance coverage, risk
factors and the control environment, etc. The above assessments are subjected
to data quality check which may be based on a peer review of the estimates
made by the business expert, internal audit, etc. The data can be fed into an
internal model for generating economic capital requirements for operational risk.
4.12 Risk assessment should also identify and evaluate the internal and external
factors that could adversely affect the bank’s performance, information and
compliance by covering all risks faced by the bank that operate at all levels within
the bank. Assessment should take account of both historical and potential risk
events.
4.13 Historical risk events are assessed based on:
(i) Total number of risk events
(ii) Total financial reversals
(iii) Net financial impact
(iv) Exposure: Based on expected increase in volumes
(v) Total number of customer claims paid out
(vi) IT indices: Uptime etc.
(vii) Office Accounts Status.
4.14 The factors for assessing potential risks include:
(i) Staff related factors such as productivity, expertise, turnover
(ii) Extent of activity outsourced
(iii) Process clarity, complexity, changes
(iv) IT Indices
(v) Audit Scores
(vi) Expected changes or spurts in volumes
CHAPTER 5
Monitoring of Operational Risk
5.1 An effective monitoring process is essential for adequately managing
operational risk. Regular monitoring activities can offer the advantage of quickly
detecting and correcting deficiencies in the policies, processes and procedures
for managing operational risk. Promptly detecting and addressing these
deficiencies can substantially reduce the potential frequency and/or severity of a
loss event.
5.2 In addition to monitoring operational loss events, banks should identify
appropriate indicators that provide early warning of an increased risk of future
losses. Such indicators (often referred to as early warning indicators) should be
forward-looking and could reflect potential sources of operational risk such as
rapid growth, the introduction of new products, employee turnover, transaction
breaks, system downtime, and so on. When thresholds are directly linked to these
indicators, an effective monitoring process can help identify key material risks in a
transparent manner and enable the bank to act upon these risks appropriately.
5.3 The frequency of monitoring should reflect the risks involved and the
frequency and nature of changes in the operating environment. Monitoring should
be an integrated part of a bank’s activities. The results of these monitoring
activities should be included in regular management and Board reports, as should
compliance reviews performed by the internal audit and/or risk management
functions. Reports generated by (and/or for) intermediary supervisory authorities
may also inform the corporate monitoring unit which should likewise be reported
internally to senior management and the Board, where appropriate.
5.4 Senior management should receive regular reports from appropriate areas
such as business units, group functions, the operational risk management unit
and internal audit. The operational risk reports should contain internal financial,
operational, and compliance data, as well as external market information about
events and conditions that are relevant to decision making. Reports should be
distributed to appropriate levels of management and to areas of the bank on
which areas of concern may have an impact. Reports should fully reflect any
identified problem areas and should motivate timely corrective action on
outstanding issues. To ensure the usefulness and reliability of these risk reports
and audit reports, management should regularly verify the timeliness, accuracy,
and relevance of reporting systems and internal controls in general. Management
may also use reports prepared by external sources (auditors, supervisors) to
assess the usefulness and reliability of internal reports. Reports should be
analysed with a view to improving existing risk management performance as well
as developing new risk management policies, procedures and practices.
Management information systems
5.5 Banks should implement a process to regularly monitor operational risk
profiles and material exposures to losses. There should be regular reporting of
pertinent information to senior management and the Board of Directors that
supports the proactive management of operational risk. In general, the Board of
Directors should receive sufficient higher-level information to enable them to
understand the bank’s overall operational risk profile and focus on the material
and strategic implications for the business. Towards this end it would be relevant
to identify all activities and all loss events in a bank under well defined business
lines.
Business Line Identification
5.6 Banks have different business mixes and risk profiles. Hence the most
intractable problem banks face in assessing operational risk capital is due to this
diversity. The best way to get around this intractable problem in computation is by
specifying a range of operational risk multipliers for specified distinct business
lines. The following benefits are expected to accrue by specifying business lines:
� banks will be able to crystallise the assessment processes to the
underlying operational risk and the regulatory framework;
� the line managers will be aware of operational risk in their line of
business;
� confusion and territorial overlap which may be linked to subsets of the
overall risk profile of a bank can be avoided.
5.7 For the purpose of operational risk management, the activities of a bank
may be mapped into eight business lines identified in the New Capital Adequacy
Framework. The various products launched by the banks are also to be mapped
to the relevant business line. Banks must develop specific policies for mapping a
product or an activity to a business line and have the same documented to
indicate the criteria. The following are the eight recommended business lines.
Details and methodologies for mapping of these business lines are furnished in
Annex 2.
1. Corporate finance2. Trading and sales3. Retail banking4. Commercial banking5. Payment and settlement6. Agency services7. Asset management8. Retail brokerage
5.8 The following are the principles to be followed for business line mapping:
(i) All activities must be mapped into the eight level - 1 business lines in amutually exclusive and jointly exhaustive manner.
(ii) Any banking or non banking activity which cannot be readily mapped intothe business line framework, but which represents an ancillary function toan activity included in the framework, must be allocated to the business lineit supports. If more than one business line is supported through theancillary activity, an objective mapping criteria must be used.
(iii) The mapping of activities into business lines for operational riskmanagement must be consistent with the definitions of business lines usedfor management of other risk categories, i.e. credit and market risk. Anydeviations from this principle must be clearly motivated and documented.
(iv) The mapping process used must be clearly documented. In particular,written business line definitions must be clear and detailed enough to allowthird parties to replicate the business line mapping. Documentation must,among other things, clearly motivate any exceptions or overrides and bekept on record.
(v) Processes must be in place to define the mapping of any new activities orproducts.
(vi) Senior management is responsible for the mapping policy (which is subjectto approval by the Board of Directors).
(vii) The mapping process to business lines must be subject to independentreview.
5.9 The following principles might be relevant for determining mapping of
activities into appropriate business lines:
i) activities that constitute compound activities may be broken up into their
components which might be related to the level 2 activities under the eight
business lines and these components of the complex activity may be
assigned to the most suitable business lines, in accordance with their
nature and characteristics.
ii) activities that refer to more than a business line may be assigned to the
most predominant business line and if no predominant business line exist,
then it may be mapped to the most suitable business lines, in accordance
with their nature and characteristics.
Operational Risk Loss events
5.10 Banks must meet the following data requirement for internally generating
operational risk measures.
� The tracking of individual internal event data is an essential prerequisite tothe development and functioning of operational risk measurement system.Internal loss data is crucial for tying a bank’s risk estimates to its actualloss experience.
� Internal loss data is most relevant when it is clearly linked to a bank’scurrent business activities, technological process and risk managementprocedures. Therefore, bank must have documented procedures forassessing on-going relevance of historical loss data, including thosesituations in which judgement overrides, scaling, or other adjustments maybe used, to what extent it may used and who is authorised to make suchdecisions.
� Bank’s internal loss data must be comprehensive in that it captures allmaterial activities and exposures from all appropriate sub-systems andgeographic locations. A bank must be able to justify that any activities andexposures excluded would not have a significant impact on the overall riskestimates. Bank may have appropriate de minimis gross loss threshold forinternal loss data collection, say Rs.10, 000. The appropriate threshold mayvary somewhat between banks and within a bank across business linesand / or event types. However, particular thresholds may be broadlyconsistent with those used by the peer banks. Measuring Operational Risk
requires both estimating the probability of an operational loss event and theseverity of the loss.
� Banks must track actual loss data (i.e., where losses have actuallymaterialised) and map the same into the relevant level 1 category definedin Annex 3. Banks must endeavour to map the actual loss events to level 3.Operational risk loss would be the financial impact associated with theoperational event that is recorded in the financial statement and wouldinclude for example, (a) loss incurred, and (b) expenditure incurred toresume normal functioning, but would not include opportunity costs andforegone revenue etc. However, the banks must also track the potentialloss (i.e. extent to which further loss may be incurred due to the sameoperational risk event), near misses, attempted frauds, etc where no losshas actually been incurred by the bank, from the point of view ofstrengthening the internal systems and controls and avoiding the possibilityof such events turning into actual operational risk losses in future.
� Aside from information on gross loss amounts, bank should collectinformation about the data of the event, any recoveries, as well as somedescriptive information about the cause/drivers of the loss event. The levelof descriptive information should be commensurate with the size of thegross loss amount.
� Bank must develop specific criteria for assigning loss data arising from anevent in a centralised function (e.g. information technology, administrationdepartment etc.) or any activity that spans more than one business line.
� External loss data – bank may also collect external loss data to the extentpossible. External loss data should include data on actual loss amounts,information on scale of business operations where the event occurred,information on causes and circumstances of the loss events or any otherrelevant information. Bank must develop systematic process fordetermining the situations for which external data should be used and themethodologies used to incorporate the data.
� The loss data collected must be analysed loss event category andbusiness line wise. Banks to look into the process and plug anydeficiencies in the process and take remedial steps to reduce such events.
CHAPTER 6
Controls / Mitigation of Operational Risk
6.1 Risk management is the process of mitigating the risks faced by a bank. With
regard to operational risk, several methods may be adopted for mitigating the risk.
For example, losses that might arise on account of natural disasters can be
insured against. Losses that might arise from business disruptions due to
telecommunication or electrical failures can be mitigated by establishing
redundant backup facilities. Loss due to internal factors, like employee fraud or
product flaws, which may be difficult to identify and insure against, can be
mitigated through strong internal auditing procedures.
6.2 Although a framework of formal, written policies and procedures is critical, it
needs to be reinforced through a strong control culture that promotes sound risk
management practices. Both the Board of Directors and senior management are
responsible for establishing a strong internal control culture in which control
activities are an integral part of the regular activities of a bank, since such
integration enables quick responses to changing conditions and avoids
unnecessary costs.
6.3 A system of effective internal controls is a critical component of bank
management and a foundation for the safe and sound operation of banking
organisations. Such a system can also help to ensure that the bank will comply
with laws and regulations as well as policies, plans, internal rules and procedures,
and decrease the risk of unexpected losses or damage to the bank’s reputation.
Internal control is a process effected by the Board of Directors, senior
management and all levels of personnel. It is not solely a procedure or policy that
is performed at a certain point in time, but rather it is continually operating at all
levels within the bank.
6.4 The internal control process, which historically has been a mechanism for
reducing instances of fraud, misappropriation and errors, has become more
extensive, addressing all the various risks faced by banking organisations. It is
now recognised that a sound internal control process is critical to a bank’s ability
to meet its established goals, and to maintain its financial viability.
6.5 In varying degrees, internal control is the responsibility of everyone in a
bank. Almost all employees produce information used in the internal control
system or take other actions needed to effect control. An essential element of a
strong internal control system is the recognition by all employees of the need to
carry out their responsibilities effectively and to communicate to the appropriate
level of management any problems in operations, instances of non-compliance
with the code of conduct, or other policy violations or illegal actions that are
noticed. It is essential that all personnel within the bank understand the
importance of internal control and are actively engaged in the process. While
having a strong internal control culture does not guarantee that an organisation
will reach its goals, the lack of such a culture provides greater opportunities for
errors to go undetected or for improprieties to occur.
6.6 An effective internal control system requires that
• an appropriate control structure is set up, with control activities defined at
every business level. These should include: top level reviews; appropriate
activity controls for different departments or divisions; physical controls;
checking for compliance with exposure limits and follow-up on non-
compliance; a system of approvals and authorisations; and, a system of
verification and reconciliation.
• there is appropriate segregation of duties and personnel are not assigned
conflicting responsibilities. Areas of potential conflicts of interest should be
identified, minimised, and subject to careful, independent monitoring.
• there are adequate and comprehensive internal financial, operational and
compliance data, as well as external market information about events and
conditions that are relevant to decision making. Information should be
reliable, timely, accessible, and provided in a consistent format.
• there are reliable information systems in place that cover all significant
activities of the bank. These systems, including those that hold and use
data in an electronic form, must be secure, monitored independently and
supported by adequate contingency arrangements.
• effective channels of communication to ensure that all staff fully understand
and adhere to policies and procedures affecting their duties and
responsibilities and that other relevant information is reaching the
appropriate personnel.
6.7 Adequate internal controls within banking organisations must be
supplemented by an effective internal audit function that independently evaluates
the control systems within the organisation. Internal audit is part of the ongoing
monitoring of the bank's system of internal controls and of its internal capital
assessment procedure, because internal audit provides an independent
assessment of the adequacy of, and compliance with, the bank’s established
policies and procedures.
6.8 Operational risk can be more pronounced where banks engage in new
activities or develop new products (particularly where these activities or products
are not consistent with the bank’s core business strategies), enter unfamiliar
markets, and/or engage in businesses that are geographically distant from the
head office. It is incumbent upon banks to ensure that special attention is paid to
internal control activities where such conditions exist.
6.9 In some instances, banks may decide to either retain a certain level of
operational risk or self-insure against that risk. Where this is the case and the risk
is material, the decision to retain or self-insure the risk should be transparent
within the organisation and should be consistent with the bank’s overall business
strategy and appetite for risk. The bank’s appetite as specified through the policies
for managing this risk and the bank’s prioritisation of operational risk management
activities, including the extent of, and manner in which, operational risk is
transferred outside the bank. The degree of formality and sophistication of the
bank’s operational risk management framework should be commensurate with the
bank’s risk profile.
6.10 Banks should have policies, processes and procedures to control and/or
mitigate material operational risks. Banks should periodically review their risk
limitation and control strategies and should adjust their operational risk profile
accordingly using appropriate strategies, in light of their overall risk appetite and
profile.
� For all material operational risks that have been identified, the bank shoulddecide whether to use appropriate procedures to control and/or mitigatethe risks, or bear the risks. For those risks that cannot be controlled, thebank should decide whether to accept these risks, reduce the level ofbusiness activity involved, or withdraw from this activity completely. Controlprocesses and procedures should be established and banks should have asystem in place for ensuring compliance with a documented set of internalpolicies.
� Some significant operational risks have low probabilities but potentiallyvery large financial impact. Classification of operational loss event intovarious risk categories based on frequency and severity matrixprioritise the events to be controlled and tracked. Audit benchmarks can beset for high loss events. Moreover, not all risk events can be controlled(e.g., natural disasters). Risk mitigation tools or programmes can be usedto reduce the exposure to, or frequency and/or severity of, such events.For example, insurance policies, particularly those with prompt and certainpay-out features, can be used to externalise the risk of “low frequency,high severity” losses which may occur as a result of events such as third-party claims resulting from errors and omissions, physical loss ofsecurities, employee or third-party fraud, and natural disasters.
� However, banks should view risk mitigation tools as complementary to,rather than a replacement for, internal operational risk control. Havingmechanisms in place to quickly recognise and rectify legitimate operationalrisk errors can greatly reduce exposures. Careful consideration also needsto be given to the extent to which risk mitigation tools such as insurancetruly reduce risk, or transfer the risk to another business sector or area, oreven create a new risk (e.g. legal or counterparty risk).
� Investment in appropriate processing technology and informationtechnology security are also important for risk mitigation. However, banksshould be aware that increased automation could transform highfrequency-low severity losses into low frequency-high severity losses. Thelatter may be associated with loss or extended disruption of servicescaused by internal factors or by factors beyond the bank’s immediatecontrol (e.g., external events). Such problems may cause seriousdifficulties for banks and could jeopardise an institution’s ability to conductkey business activities. Banks should establish disaster recovery andbusiness continuity plans that address this risk.
� Banks should also establish policies for managing risks associated withoutsourcing activities. Outsourcing of activities can reduce the institution’srisk profile by transferring activities to others with greater expertise andscale to manage the risks associated with specialised business activities.However, a bank’s use of third parties does not diminish the responsibilityof management to ensure that the third-party activity is conducted in a safeand sound manner and in compliance with applicable laws. Outsourcingarrangements should be based on robust contracts and/or service levelagreements that ensure a clear allocation of responsibilities betweenexternal service providers and the outsourcing bank. Furthermore, banksneed to manage residual risks associated with outsourcing arrangements,including disruption of services
� Depending on the scale and nature of the activity, banks shouldunderstand the potential impact on their operations and their customers ofany potential deficiencies in services provided by vendors and other third-party or intra-group service providers, including both operationalbreakdowns and the potential business failure or default of the externalparties. Banks should ensure that the expectations and obligations of eachparty are clearly defined, understood and enforceable. The extent of theexternal party’s liability and financial ability to compensate the bank forerrors, negligence, and other operational failures should be explicitlyconsidered as part of the risk assessment. Banks should carry out an initialdue diligence test and monitor the activities of third party providers,especially those lacking experience of the banking industry’s regulatedenvironment, and review this process (including re-evaluations of duediligence) on a regular basis. For critical activities, the bank may need toconsider contingency plans, including the availability of alternative externalparties and the costs and resources required to switch external parties,potentially on very short notice.
� Banks should have in place contingency and business continuity plans toensure their ability to operate on an ongoing basis and limit losses in theevent of severe business disruption. These plans needs to be stress-tested annually and the plans may be revised to appropriately address anynew or previously unaddressed parameters for these plans. For reasonsthat may be beyond a bank’s control, a severe event may result in theinability of the bank to fulfil some or all of its business obligations,particularly where the bank’s physical, telecommunication, or informationtechnology infrastructures have been damaged or made inaccessible. Thiscan, in turn, result in significant financial losses to the bank, as well asbroader disruptions to the financial system through channels such as thepayments system. This potential requires that banks establish disasterrecovery and business continuity plans that take into account differenttypes of plausible scenarios to which the bank may be vulnerable,commensurate with the size and complexity of the bank’s operations.
� Banks should periodically review their disaster recovery and businesscontinuity plans so that they are consistent with the bank’s currentoperations and business strategies. Moreover, these plans should be
tested periodically to ensure that the bank would be able to execute theplans in the unlikely event of a severe business disruption.
Chapter 7
Independent Evaluation of Operational Risk Management Function
7.1 The bank’s Board of Directors has the ultimate responsibility for ensuring
that senior management establishes and maintains an adequate and effective
system of internal controls, a measurement system for assessing the various risks
of the bank’s activities, a system for relating risks to the bank’s capital level, and
appropriate methods for monitoring compliance with laws, regulations, and
supervisory and internal policies.
7.2 Internal audit is part of the ongoing monitoring of the bank's system of
internal controls because internal audit provides an independent assessment of
the adequacy of, and compliance with, the bank’s established policies and
procedures. As such, the internal audit function assists senior management and
the Board of Directors in the efficient and effective discharge of their
responsibilities as described above. Banks should have in place adequate internal
audit coverage to verify that operating policies and procedures have been
implemented effectively. The Board (either directly or indirectly through its Audit
Committee) should ensure that the scope and frequency of the audit programme
is appropriate to the risk exposures.
7.3 The scope of internal audit will broadly cover:
� the examination and evaluation of the adequacy and effectiveness ofthe internal control systems and the functioning of specific internal controlprocedures;
� the review of the application and effectiveness of operational riskmanagement procedures and risk assessment methodologies;
� the review of the management and financial information systems,including the electronic information system and electronic banking services;
� the review of the means of safeguarding assets;
� the review of the bank’s system of assessing its capital in relation to itsestimate of operational risk;
� the review of the systems established to ensure compliance with legaland regulatory requirements, codes of conduct and the implementation ofpolicies and procedures;
� the testing of the reliability and timeliness of the regulatory reporting;
� mitigating risks through risk based audit
7.4 All functional departments should ensure that the operational risk
management department is kept fully informed of new developments, initiatives,
products and operational changes to ensure that all associated risks are identified
at an early stage.
� Operational risk groups are likely to focus on regulatory liaison,operational risk measures, best practice in areas involving riskquantification such as model risk, new products approval and optimisingoperations and processes. Audit should periodically validate that thebank’s operational risk management framework is being implementedeffectively across the bank. To the extent that the audit function isinvolved in oversight of the operational risk management framework, theBoard should ensure that the independence of the audit function ismaintained. This independence may be compromised if the audit functionis directly involved in the operational risk management process. The auditfunction may provide valuable input to those responsible for operationalrisk management, but should not itself have direct operational riskmanagement responsibilities.
� Examples of what an independent evaluation of operational risk shouldreview include the following:
� The effectiveness of the bank’s risk management process and overall
control environment with respect to operational risk;
� The bank’s methods for monitoring and reporting its operational riskprofile, including data on operational losses and other indicators ofpotential operational risk;
� The bank’s procedures for the timely and effective resolution ofoperational risk events and vulnerabilities;
� The effectiveness of the bank’s operational risk mitigation efforts,such as the use of insurance;
� The quality and comprehensiveness of the bank’s disaster recoveryand business continuity plans
� To ensure that, where banks are part of a financial group, there areprocedures in place to ensure that operational risk is managed in anappropriate and integrated manner across the group. In performing
this assessment, cooperation and exchange of information with othersupervisors, in accordance with established procedures, may benecessary.
Chapter 8
Capital Allocation for Operational Risk
8.1 This Guidance Note is an outline of a set of sound principles for effective
management and supervision of operational risk by banks. As mentioned earlier,
the exact approach may differ among banks and the operational risk management
chosen by a bank would depend on a broad range of factors.
8.2 The Basel Committee has put forward a framework consisting of three options
for calculating operational risk capital charges in a ‘continuum’ of increasing
sophistication and risk sensitivity. These are, in the order of their increasing
complexity, viz., (i) the Basic Indicator Approach (ii) the Standardised Approach
and (iii) Advanced Measurement Approaches. Though the Reserve Bank
proposes to initially allow banks to use the Basic Indicator Approach for computing
regulatory capital for operational risk, some banks are expected to move along the
range toward more sophisticated approaches as they develop more sophisticated
operational risk management systems and practices which meet the prescribed
qualifying criteria. Qualifying criteria for standardised Approach and Advanced
Measurement Approaches are given in the Attachment. In order to have a better
understanding of these approaches, it is suggested that the Attachment should be
read together with the revised Framework.
The Basic Indicator Approach
8.3 Reserve Bank has proposed that, at the minimum, all banks in India should
adopt this approach while computing capital for operational risk while
implementing Basel II. Under the Basic Indicator Approach, banks have to hold
capital for operational risk equal to a fixed percentage (alpha) of a single indicator
which has currently been proposed to be “gross income”. This approach is
available for all banks irrespective of their level of sophistication. The charge may
be expressed as follows:
KBIA = [ ∑ (GI*αααα) ]/n,
Where
KBIA = the capital charge under the Basic Indicator Approach.
GI = annual gross income, where positive, over the previous threeyears
αααα = 15% set by the Committee, relating the industry-wide level ofrequired capital to the industry-wide level of the indicator.
n = number of the previous three years for which gross income ispositive.
8.4 The Basel Committee has defined gross income as net interest income and
has allowed each relevant national supervisor to define gross income in
accordance with the prevailing accounting practices. Accordingly, gross income
will be computed for this purpose as defined by the Reserve Bank of India for
implementation of the new capital adequacy framework.
Annex 1
(paragraph 2.9)
Broad indicative role of each organisational armof the risk management structure
A. Key functions of Risk Management Committee of Board (RMCB)
• Approve operational risk policies and issues delegated to it by the Board.
• Review profiles of operational risk throughout the organization
• Approve operational risk capital methodology and resulting attribution
• Set and approve expressions of risk appetite, within overall parameters set bythe Board.
• Re-enforce the culture and awareness of operational risk managementthroughout the organization.
B. Key functions of Operational Risk Management Committee
The Operational Risk Management Committee is an executive committee. It shall
have as its principal objective the mitigation of operational risk within the institution
by the creation and maintenance of an explicit operational risk management
process. The committee will be presented with detailed reviews of operational risk
exposures across the bank. Its goals are to take a cross-business view and
assure that a proper understanding is reached and actions are being taken to
meet the stated goals and objectives of operational risk management in the bank.
The Committee may meet quarterly, or more often as it determines is necessary.
The meetings will focus on all operational risk issues that the bank faces. Key
roles of the Committee are:
• Review the risk profile, understand future changes and threats, and concur onareas of highest priority and related mitigation strategy.
• Assure adequate resources are being assigned to mitigate risks as needed
• Communicate to business areas and staff components the importance ofoperational risk management, and assure adequate participation andcooperation
• Review and approve the development and implementation of operational riskmethodologies and tools, including assessments, reporting, capital and lossevent databases.
• Receive and review reports/presentations from the business lines and otherareas about their risk profile and mitigation programs.
• To monitor and ensure that appropriate operational risk managementframeworks are in place.
• To proactively review and mange potential risks which may arise fromregulatory changes/or changes in economic /political environment in order tokeep ahead.
• To discuss and recommend suitable controls/mitigations for managingoperational risk.
• To analyse frauds, potential losses, non compliance, breaches etc. andrecommend corrective measures to prevent recurrences.
• To discuss any issues arising / directions in any one business unit/productwhich may impact the risks of other business/products.
• To continually promote risk awareness across all business units so thatcomplacency does not set in.
C. Key functions of Operational Risk Management Department (ORMD)
The ORMD is responsible for coordinating all the operational risk activities of the
Bank, working towards achievement of the stated goals and objectives. Activities
include building an understanding of the risk profile, implementing tools related to
operational risk management, and working towards the goals of improved controls
and lower risk. ORMD works with the operational liaisons within the business
units, staff areas and with the corporate management staff. The group is
organized within the Risk Management function. Specific activities of the ORMD
include:
• Risk Profile – ORMD will work with all areas of the bank and assembleinformation to build an overall risk profile of the institution, understand andcommunicate these risks, and analyze changes/trends in the risk profile.ORMD will utilize the following four-pronged approach to develop theseprofiles:
• Risk Indicators
• Self-Assessment
• Loss Database
• Capital Model
• Tools – ORMD is responsible for the purchase or development andimplementation of tools that the Bank will use in its operational riskmanagement program.
• Capital – ORMD is jointly responsible with the department involved in capitalmanagement for development of a capital measurement methodology foroperational risks. It will also coordinate the assembly of required inputs,documentation of assumptions, gaining consensus with the business areas,and coordination with other areas of the bank for the use of the results in thestrategic planning, performance measurement, cost benefit analysis, andpricing processes.
• Consolidation and Reporting of Data – ORMD will collect relevantinformation from all areas of the bank, build a consolidated view of operationalrisk, assemble summary management reports and communicate the results tothe risk committees or other interested parties. Key information will includerisk indicators, event data and self-assessment results and related issues.
• Analysis of Data – ORMD is responsible to analyze the data on aconsolidated basis, on an individual basis and on a comparative basis.
• Best Practices – ORMD will identify best practices from within the bank orfrom external sources and share these practices with management and riskspecialists across the Bank as beneficial. As part of this role, they willparticipate in industry conferences surveys, keep up to date on rules andregulations, monitor trends and practices in the industry, and maintain adatabase/library of articles on the subject.
• Advice/Consultation – ORMD will be responsible for working with the RiskSpecialists and the businesses as a team to provide advice on how to applythe operational risk management framework, identify operational risks andwork on solving problems and improving the risk profile of the Bank.
• Insurance – ORMD will work with the Bank’s insurance area to determineoptimal insurance limits and coverage to assure that the insurance policies thebank purchases are cost beneficial and align with the operational risk profilesof the Bank.
• Policies – ORMD will be responsible for drafting, presenting, updating andinterpreting, the Operational Risk Policy.
• Self-Assessment – ORMD will be responsible for facilitating periodic self-assessments for the purpose of identifying and monitoring operational risks.
• Coordination with Internal Audit –ORMD will work closely with Internal Auditto plan assessments and concerns about risks in the Bank. ORMD and
Internal Audit will share information and coordinate activities so as to minimizepotential overlap of activities.
D. Key functions of Chief Risk Officer (CRO)
The CRO has supervisory responsibilities over the Operational Risk Management
Department as well as responsibility over market risk and credit risk:
• Review Recommendations –The CRO will supervise the activities and reviewand approve the recommendations of the ORMD before submission to theOperational Risk Committee or Risk Management Committee.
• Assess interrelationships between Operational, and other risk types –The CRO will facilitate the analysis of risks and interrelationships of risksacross market, credit and operational risks. The CRO will assurecommunication between risk functions and that risk measures and economiccapital measures reflect any interrelationships.
• Create Awareness – The CRO will help assure that line and executivemanagement maintains an ongoing understanding of operational risks andparticipates in related risk management activities.
E. Key function of Operational Risk Management Specialists
The bank-wide support departments (e.g., Legal, Human Resources, and
Information Technology) shall assign a representative(s) to be designated as
Operational Risk Specialists. Their main responsibility is to work with ORMD and
the departments/businesses to identify, analyze, explain and mitigate operational
issues within their respective areas of expertise. They will also act as verifiers for
their related risks in the self assessment process. They will accomplish this
responsibility by involving themselves in the following:
• Committee Participation – The Operational Risk Management Specialistsshall be members of the committees and task forces related to operational riskmanagement, as applicable. They must be ready to discuss operationalissues and recommend mitigation strategies.
• Risk-Indicators – Assist in the development and review of appropriate riskindicators, both on a bank-wide and business specific basis for their area ofspecialty.
• Self-Assessment – Assist in the review of Self-Assessment results and opineon the departmental/business assessment of risk types, quantification andfrequency.
• Loss Database – Assist in the timely identification and recording ofoperational loss data and explanations.
• Gaps/Issues – Ensure that all operational risk issues are brought to theattention of ORMD and the Department/business.
• Mitigation – Assist the department/business in the design and implementationof risk mitigation strategies.
F. Key functions of Business Operational Risk Managers
It is expected that each business/ functional area will appoint a person responsible
to coordinate the management of operational risk. This responsibility may be
assigned to an existing job, be a full time position, or even a team of people, as
the size and complexity justify. Business/Functional areas should determine how
this should be organized within their respective areas. Risk Managers will report to
their respective departments/businesses, but work closely with ORMD and with
consistent tools and risk management framework and policy. The Operational
Risk Management Committee will assure that these liaisons are appointed and
approve their selection. The key responsibilities of the liaisons are:
• Self-Assessments – Will help facilitate, partake and verify the results of theself-assessment process.
• Risk Indicators – Design, collection, reporting, and data capture of riskindicators and related reports. Liaisons will monitor results and help work withtheir respective departments on identified issues. Resulting information will bedistributed to both the departments and ORMD on a timely and accurate basis.
• Loss Events – Coordinate collection, recording and data capture of lossevents within the businesses and regular reporting of these events, the details,amounts.
• Gaps/Issues – Responsible for the timely follow-up, documentation and statusof action plans, open issues (Internal Audit, External Audit, Regulator andInspector) and other initiatives waiting to be completed.
• Committee Participation – Must prepare to be called upon to attend theOperational Risk Management Committee meetings, when necessary, todiscuss operational risk issues.
• Risk Mitigation – Responsible for consulting/advising the business units onways to mitigate risks. Work with business areas and respective departmentson risk analysis and mitigation.
G. Key functions of Department Heads
Business/Functional area heads are responsible for risk taking, related controls
and mitigation. They are ultimately responsible for implementation of sound risk
management practices and any resulting impact for operational losses. To
support this responsibility, they will have the following responsibilities related to
operational risk management.
• Risk Ownership – The department heads shall take ownership of theoperational risks faced in their departments/businesses.
• Understanding – Understanding the profile of operational risk facing the areaand monitoring changes in the business and risk profile. Department Headsmay be expected to present their risk profiles and action plans to theOperational Risk Management Committee.
• Risk Indicators – Collection and Preparation of various risk indicator reports.
• Loss Events - Identification of loss events within the businesses and regularreporting of these events, the details, amounts and circumstances to ORMDon a complete and timely basis.
• Self-Assessment – Responsible for the periodic completion of self-assessments.
• Risk Mitigation – The businesses are responsible for developing strategiesfor the mitigation of risk where required (or managing those risks deemed tobe acceptable).
ANNEX 2(Paragraph 5.7)
Mapping of Business Lines
BuisnessUnit Business line Activity Groups
Level 1 Level 2
Corporate Finance
Municipal / governmentfinance
Merchant Banking
CorporateFinance
Advisory Services
Mergers and Acquisitions,Underwriting, Privatisations,Securitisation, Research, Debt(Government, High Yield) Equity,Syndications, IPO, SecondaryPrivate Placements.
Sales
Market Making
Proprietary Positions
InvestmentBanking
Trading andsales
Treasury
Fixed Income, equity, foreignexchanges, commodities, credit,funding, own position securitieslending and repos, brokerage, debt,prime brokerage.
Retail Banking Retail lending and deposits,banking services, trust and estates
Private Banking Private lending and deposits,banking services, trust and estates,investment advice.
Retail Banking
Card Services Merchant/Commercial/Corporatecards, private labels and retail.
CommercialBanking
Commercial Banking Project finance, real estate, exportfinance, trade finance, factoring,leasing, lends, guarantees, bills ofexchange
Payment andSettlement
External Clients Payments and collections, fundstransfer, clearing and settlement.
Custody Escrow, Depository Receipts,Securities lending (Customers)Corporate actions
Corporate Agency Issuer and paying agents
Banking
Agency Services
Corporate Trust
Discretionary FundManagement
Pooled, segregated, retail,institutional, closed, open, privateequity
AssetManagement
Non - DiscretionaryFund Management
Pooled, segregated, retail,institutional, closed, open
Others
Retail Brokerage Retail Brokerage Execution and full service
ANNEX 3(Paragraph 5.9 )
Loss Event Type Classification
Category (Level 1) Definition Category (Level 2) Category (Level 3)
Transactions notreported (intentional)
Trans typeunauthorized(monetary loss)
Unauthorizedactivity
Mismarking ofposition (intentional)
Fraud/ credit fraud/worthless deposits
Theft / extortion /embezzlement /robbery
Misappropriation ofassets
Malicious destructionof assets
Forgery
Check kiting
Smuggling
Account take-over /impersonation /etc.
Tax non-compliance/evasion (willful)
Bribes/ kickbacks
Internal Fraud Lossess due to actsof a type intended todefraud,misappropriateproperty orcircumventregulations, the law orcompany policy,excluding diversity /discrimination events,which involves atleast one internalparty.
Theft and Fraud
Insider trading (not onbank’s account)
Theft/ robbery
Forgery
Theft and Fraud
Cheque Kiting
Hacking damage Systems Security
Theft of information
External Fraud Lossess due to actsof a type intended todefraud,misappropriateproperty orcircumvent the law, bya third party.
Compensation,benefit, terminationissues
Employee Relations
Organized laboractivity
General liability(Workplace accidents- slip & fall etc)
EmploymentPractices andWorkplace Safety
Lossess arising fromacts inconsistent withemployment, health orsafety laws oragreements, frompayment of personalinjury claims, or fromdiversity /discrimination events.
Environmentalsafety
Employee health &safety rules events
Loss Event Type Classification
Category (Level 1) Definition Category (Level 2) Category (Level 3)
Workerscompensation
All discriminationtypes
Diversity anddiscrimination
Fiduciary breaches /guideline violations
Suitability / disclosureissues (KYC etc)
Retail consumerdisclosure violations
Breach of privacy
Aggressive sales
Account churning
Misuse of confidentialinformation
Suitability,Disclosure &Fiduciary
Lender Liability
Antitrust
Improper trade /market practices
Market manipulation
Insider trading
Unlicensed activity
Improper Businessor Market Practices
Money laundering
Product defects(unauthorized etc.)
Product flaws
Model errors
Failure to investigateclient per guidelines
Selection,Sponsorship &Exposure Exceeding client
exposure limits
Advisory activities Disputes overperformance ofadvisory activities
Clients, Products& BusinessPractices
Lossess arising froman unintentional ornegligent failure tomeet a professionalobligation to specificclients (includingfiduciary andsuitabilityrequirements), or fromthe nature or designof a product.
Natural disasterlosses
Human losses fromexternal sources(terrorism, vandalism)
Damage tophysical assets
Losses arising fromloss or damage tophysical assets fromnatural disasters orother events
Disasters and otherevents
Loss Event Type Classification
Category (Level 1) Definition Category (Level 2) Category (Level 3)
Hardware
Software
Telecommunications
Utility outrage /disruptions
Businessdisruption &system failures
Losses arising fromdisruption of businessor system failures
Systems
Miscommunication
Data entry,maintenance orloading error
Missed deadline orresponsibility
Model / systemmisoperation
Accounting error /entity attribution error
Other taskmisperformance
Delivery failure
Collateralmanagement failure
TransactionCapture, ExecutionMaintenance
Reference datamaintenance
Failed mandatoryreporting obligation
Monitoring andReporting
Inaccurate externalreport (loss incurred)
Client permissions/disclaimers missing
Customer intakeand documentation
Legal documentsmissing / incomplete
Unapproved accessgiven to accounts
Incorrect clientrecords (loss incurred)
Customer clientaccountmanagement
Negligent lossdamage of clientassets
Non clientcounterpartymisperformance
TradeCounterparties
Misc. non-clientcounterparty disputes
Outsourcing
Execution,Delivery &ProcessManagement
Losses from failedtranscationsprocessing or processmanagement, fromrelations with tradecounterparties andvendors
Vendors &Suppliers Vendor disputes
ATTACHMENT(Paragraph 8.2)
Advanced Measurement Methodologies
It is suggested that for a better comprehension, this attachment should be read
together with the "International Convergence of Capital Measurement and Capital
Standards – A Revised Framework" released by the Basel Committee on Banking
Supervision in June 2004.
The Standardised Approach
2. In the Standardised Approach, banks‘ activities are divided into eight business
lines: corporate finance, trading & sales, retail banking, commercial banking,
payment & settlement, agency services, asset management, and retail brokerage.
The business lines are defined in detail in Annex 3 (Para 5.9).
3. Within each business line, gross income is a broad indicator that serves as a
proxy for the scale of business operations and thus the likely scale of operational
risk exposure within each of these business lines. The capital charge for each
business line is calculated by multiplying gross income by a factor (denoted beta)
assigned to that business line. Beta serves as a proxy for the industry-wide
relationship between the operational risk loss experience for a given business line
and the aggregate level of gross income for that business line. It should be noted
that in the Standardised Approach gross income is measured for each business
line, not the whole institution, i.e. in corporate finance, the indicator is the gross
income generated in the corporate finance business line.
4. The total capital charge is calculated as the simple summation of the regulatory
capital charges across each of the business lines. The total capital charge may be
expressed as:
KTSA = {ΣΣΣΣ1-3 years max [∑ (GI1-8*ββββ1-8 ),0]}/3
Where:
KTSA = the capital charge under the Standardised Approach
GI1-8 = annual gross income in a given year, for each business lines
β1-8 = a fixed percentage, set by the Committee, relating the level ofrequired capital to the level of the gross income for each of the 8business lines. The values of the β are detailed below:
Business Lines IndicatorBeta factors
(%)Beta
values (%)
Corporate finance Gross income β1 18
Trading and sales Gross income β2 18
Retail banking Gross income β3 12
Commercial banking Gross income β4 15
Payment and settlement Gross income β5 18
Agency services Gross income β6 15
Asset management Gross income β7 12
Retail brokerage Gross income β8 12
Qualifying Criteria for Standardised Approach
5. In order to qualify for use of the Standardised Approach, a bank must satisfy its
supervisor that, at a minimum:
• Its Board of Directors and senior management, as appropriate, are actively
involved in the oversight of the operational risk management framework;
• It has an operational risk management system that is conceptually sound
and is implemented with integrity; and
• It has sufficient resources in the use of the approach in the major business
lines as well as the control and audit areas.
6. Supervisors will have the right to insist on a period of initial monitoring of a
bank's Standardised Approach before it is used for regulatory capital purposes.
7. A bank must develop specific policies and have documented criteria for
mapping gross income for current business lines and activities into the
standardised framework. The criteria must be reviewed and adjusted for new or
changing business activities as appropriate. The principles for business line
mapping are set out in Annex 2 of the Guidance Note.
8. As some internationally active banks will wish to use the Standardised
Approach, it is important that such banks have adequate operational risk
management systems. Consequently, an internationally active bank using the
Standardised Approach must meet the following additional criteria (for other
banks, these criteria are recommended, with national discretion to impose them
as requirements):
(a) The bank must have an operational risk management system with
clear responsibilities assigned to an operational risk management
function. The operational risk management function is responsible for
developing strategies to identify, assess, monitor and control/mitigate
operational risk; for codifying firm-level policies and procedures
concerning operational risk management and controls; for the design
and implementation of the firm’s operational risk assessment
methodology; and for the design and implementation of a risk-
reporting system for operational risk.
(b) As part of the bank’s internal operational risk assessment system, the
bank must systematically track relevant operational risk data including
material losses by business line. Its operational risk assessment
system must be closely integrated into the risk management
processes of the bank. Its output must be an integral part of the
process of monitoring and controlling the banks operational risk
profile. For instance, this information must play a prominent role in
risk reporting, management reporting, and risk analysis. The bank
must have techniques for creating incentives to improve the
management of operational risk throughout the firm.
(c) There must be regular reporting of operational risk exposures,
including material operational losses, to business unit management,
senior management, and to the board of directors. The bank must
have procedures for taking appropriate action according to the
information within the management reports.
(d) The bank’s operational risk management system must be well
documented. The bank must have a routine in place for ensuring
compliance with a documented set of internal policies, controls and
procedures concerning the operational risk management system,
which must include policies for the treatment of non-compliance
issues.
(e) The bank’s operational risk management processes and assessment
system must be subject to validation and regular independent review.
These reviews must include both the activities of the business units
and of the operational risk management function.
(f) The bank’s operational risk assessment system (including the internal
validation processes) must be subject to regular review by external
auditors and/or supervisors.
The Alternative Standardised Approach
9. At national supervisory discretion a supervisor can choose to allow a bank to
use the Alternative Standardised Approach (ASA) provided the bank is able to
satisfy its supervisor that this alternative approach provides an improved basis by,
for example, avoiding double counting of risks. Once a bank has been allowed to
use the ASA, it will not be allowed to revert to use of the Standardised Approach
without the permission of its supervisor. It is not envisaged that large diversified
banks in major markets would use the ASA. Under the ASA, the operational risk
capital charge/methodology is the same as for the Standardised Approach except
for two business lines – retail banking and commercial banking. For these
business lines, loans and advances – multiplied by a fixed factor ‘m’ – replaces
gross income as the exposure indicator. The betas for retail and commercial
banking are unchanged from the Standardised Approach. The ASA operational
risk capital charge for retail banking (with the same basic formula for commercial
banking) can be expressed as:
KRB = βRB x m x LARB
Where
- KRB is the capital charge for the retail banking business line
- βRB is the beta for the retail banking business line
- LARB is total outstanding retail loans and advances (non-risk weighted and
gross of provisions), averaged over the past three years
- m is 0.035
10. For the purposes of the ASA, total loans and advances in the retail banking
business line consists of the total drawn amounts in the following credit portfolios:
retail, SMEs treated as retail, and purchased retail receivables. For commercial
banking, total loans and advances consists of the drawn amounts in the following
credit portfolios: corporate, sovereign, bank, specialised lending, SMEs treated as
corporate and purchased corporate receivables. The book value of securities held
in the banking book should also be included.
11. Under the ASA, banks may aggregate retail and commercial banking (if they
wish to) using a beta of 15%. Similarly, those banks that are unable to
disaggregate their gross income into the other six business lines can aggregate
the total gross income for these six business lines using a beta of 18% with
negative gross income treated at para 3 of the Standardised Approach for
operational risk.
12. As under the Standardised Approach, the total capital charge for the ASA is
calculated as the simple summation of the regulatory capital charges across each
of the eight business lines.
Advanced Measurement Approaches (AMA)
13. Under the AMA, the regulatory capital requirement will equal the risk measure
generated by the bank’s internal operational risk measurement system using the
quantitative and qualitative criteria for the AMA discussed below. Use of the AMA
is subject to supervisory approval.
14. A bank adopting the AMA may, with the approval of its host supervisors and
the support of its home supervisor, use an allocation mechanism for the purpose
of determining the regulatory capital requirement for internationally active banking
subsidiaries that are not deemed to be significant relative to the overall banking
group but are themselves subject to this Framework in accordance with the scope
of application. Supervisory approval would be conditional on the bank
demonstrating to the satisfaction of the relevant supervisors that the allocation
mechanism for these subsidiaries is appropriate and can be supported empirically.
The board of directors and senior management of each subsidiary are responsible
for conducting their own assessment of the subsidiary’s operational risks and
controls and ensuring the subsidiary is adequately capitalised in respect of those
risks.
15. Subject to supervisory approval as discussed in paragraph 23 (d) below, the
incorporation of a well-reasoned estimate of diversification benefits may be
factored in at the group-wide level or at the banking subsidiary level. However,
any banking subsidiaries whose host supervisors determine that they must
calculate stand-alone capital requirements (Scope of Application in the Revised
Framework – Part 1) may not incorporate group-wide diversification benefits in
their AMA calculations (e.g. where an internationally active banking subsidiary is
deemed to be significant, the banking subsidiary may incorporate the
diversification benefits of its own operations – those arising at the sub-
consolidated level – but may not incorporate the diversification benefits of the
parent).
16. The appropriateness of the allocation methodology will be reviewed with
consideration given to the stage of development of risk-sensitive allocation
techniques and the extent to which it reflects the level of operational risk in the
legal entities and across the banking group. Supervisors expect that AMA banking
groups will continue efforts to develop increasingly risk-sensitive operational risk
allocation techniques, notwithstanding initial approval of techniques based on
gross income or other proxies for operational risk.
17. Banks adopting the AMA will be required to calculate their capital requirement
using this approach as well as the 1988 Accord as outlined in paragraph 46 of the
Revised Framework.
(i) General standards
18. In order to qualify for use of the AMA a bank must satisfy its supervisor that, at
a minimum:
• Its board of directors and senior management, as appropriate, are activelyinvolved in the oversight of the operational risk management framework;
• It has an operational risk management system that is conceptually soundand is implemented with integrity; and
• It has sufficient resources in the use of the approach in the major businesslines as well as the control and audit areas.
19. A bank’s AMA will be subject to a period of initial monitoring by its supervisor
before it can be used for regulatory purposes. This period will allow the supervisor
to determine whether the approach is credible and appropriate. As discussed
below, a bank’s internal measurement system must reasonably estimate
unexpected losses based on the combined use of internal and relevant external
loss data, scenario analysis and bank-specific business environment and internal
control factors. The bank’s measurement system must also be capable of
supporting an allocation of economic capital for operational risk across business
lines in a manner that creates incentives to improve business line operational risk
management.
(ii) Qualitative standards
20. A bank must meet the following qualitative standards before it is permitted to
use an AMA for operational risk capital:
(a) The bank must have an independent operational risk managementfunction that is responsible for the design and implementation of the bank’soperational risk management framework. The operational risk managementfunction is responsible for codifying firm-level policies and procedures concerningoperational risk management and controls; for the design and implementation ofthe firm’s operational risk measurement methodology; for the design andimplementation of a risk-reporting system for operational risk; and for developingstrategies to identify, measure, monitor and control/mitigate operational risk.
(b) The bank’s internal operational risk measurement system must be closelyintegrated into the day-to-day risk management processes of the bank. Its outputmust be an integral part of the process of monitoring and controlling the bank’soperational risk profile. For instance, this information must play a prominent role inrisk reporting, management reporting, internal capital allocation, and risk analysis.The bank must have techniques for allocating operational risk capital to majorbusiness lines and for creating incentives to improve the management ofoperational risk throughout the firm.
(c) There must be regular reporting of operational risk exposures and lossexperience to business unit management, senior management, and to the boardof directors. The bank must have procedures for taking appropriate actionaccording to the information within the management reports.
(d) The bank’s operational risk management system must be welldocumented. The bank must have a routine in place for ensuring compliance witha documented set of internal policies, controls and procedures concerning theoperational risk management system, which must include policies for thetreatment of non-compliance issues. (e) Internal and/or external auditors must perform regular reviews of theoperational risk management processes and measurement systems. This reviewmust include both the activities of the business units and of the independentoperational risk management function.
(f) The validation of the operational risk measurement system by externalauditors and/or supervisory authorities must include the following:
• Verifying that the internal validation processes are operating in asatisfactory manner; and
• Making sure that data flows and processes associated with therisk measurement system are transparent and accessible. Inparticular, it is necessary that auditors and supervisoryauthorities are in a position to have easy access, whenever theyjudge it necessary and under appropriate procedures, to thesystem’s specifications and parameters.
(iii) Quantitative standards
AMA soundness standard
21. Given the continuing evolution of analytical approaches for operational risk,
the Committee is not specifying the approach or distributional assumptions used
to generate the operational risk measure for regulatory capital purposes.
However, a bank must be able to demonstrate that its approach captures
potentially severe ‘tail’ loss events. Whatever approach is used, a bank must
demonstrate that its operational risk measure meets a soundness standard
comparable to that of the internal ratings-based approach for credit risk, (i.e.
comparable to a one year holding period and a 99.9th percentile confidence
interval).
22. The Committee recognises that the AMA soundness standard provides
significant flexibility to banks in the development of an operational risk
measurement and management system. However, in the development of these
systems, banks must have and maintain rigorous procedures for operational risk
model development and independent model validation. Prior to implementation,
the Committee will review evolving industry practices regarding credible and
consistent estimates of potential operational losses. It will also review
accumulated data, and the level of capital requirements estimated by the AMA,
and may refine its proposals if appropriate.
Detailed criteria
23. This section describes a series of quantitative standards that will apply to
internally-generated operational risk measures for purposes of calculating the
regulatory minimum capital charge.
(a) Any internal operational risk measurement system must be consistentwith the scope of operational risk defined by the Committee in paragraph 644 ofthe Revised Framework and the loss event types defined in Annex 3.
(b) Supervisors will require the bank to calculate its regulatory capitalrequirement as the sum of expected loss (EL) and unexpected loss (UL), unlessthe bank can demonstrate that it is adequately capturing EL in its internalbusiness practices. That is, to base the minimum regulatory capital requirementon UL alone, the bank must be able to demonstrate to the satisfaction of itsnational supervisor that it has measured and accounted for its EL exposure.
(c) A bank’s risk measurement system must be sufficiently ‘granular’ tocapture the major drivers of operational risk affecting the shape of the tail of theloss estimates.
(d) Risk measures for different operational risk estimates must be addedfor purposes of calculating the regulatory minimum capital requirement. However,the bank may be permitted to use internally determined correlations in operationalrisk losses across individual operational risk estimates, provided it candemonstrate to the satisfaction of the national supervisor that its systems fordetermining correlations are sound, implemented with integrity, and take intoaccount the uncertainty surrounding any such correlation estimates (particularly inperiods of stress). The bank must validate its correlation assumptions usingappropriate quantitative and qualitative techniques.
(e) Any operational risk measurement system must have certain keyfeatures to meet the supervisory soundness standard set out in this section.These elements must include the use of internal data, relevant external data,scenario analysis and factors reflecting the business environment and internalcontrol systems.
(f) A bank needs to have a credible, transparent, well-documented andverifiable approach for weighting these fundamental elements in its overalloperational risk measurement system. For example, there may be cases whereestimates of the 99.9th percentile confidence interval based primarily on internaland external loss event data would be unreliable for business lines with a heavy-
tailed loss distribution and a small number of observed losses. In such cases,scenario analysis, and business environment and control factors, may play a moredominant role in the risk measurement system. Conversely, operational loss eventdata may play a more dominant role in the risk measurement system for businesslines where estimates of the 99.9th percentile confidence interval based primarilyon such data are deemed reliable. In all cases, the bank's approach for weightingthe four fundamental elements should be internally consistent and avoid thedouble counting of qualitative assessments or risk mitigants already recognised inother elements of the framework.
Internal data
24. Banks must track internal loss data according to the criteria set out in this
section. The tracking of internal loss event data is an essential prerequisite to the
development and functioning of a credible operational risk measurement system.
Internal loss data is crucial for tying a bank's risk estimates to its actual loss
experience. This can be achieved in a number of ways, including using internal
loss data as the foundation of empirical risk estimates, as a means of validating
the inputs and outputs of the bank's risk measurement system, or as the link
between loss experience and risk management and control decisions.
25. Internal loss data is most relevant when it is clearly linked to a bank's current
business activities, technological processes and risk management procedures.
Therefore, a bank must have documented procedures for assessing the on-going
relevance of historical loss data, including those situations in which judgement
overrides, scaling, or other adjustments may be used, to what extent they may be
used and who is authorised to make such decisions.
26. Internally generated operational risk measures used for regulatory capital
purposes must be based on a minimum five-year observation period of internal
loss data, whether the internal loss data is used directly to build the loss measure
or to validate it. When the bank first moves to the AMA, a three-year historical
data window is acceptable (this includes the parallel calculations in paragraph 46
of the Revised Framework).
27. To qualify for regulatory capital purposes, a bank's internal loss collection
processes must meet the following standards:
• To assist in supervisory validation, a bank must be able to map its historicalinternal loss data into the relevant level 1 supervisory categories defined inAnnexes 2 and 3 and to provide these data to supervisors upon request. Itmust have documented, objective criteria for allocating losses to thespecified business lines and event types. However, it is left to the bank todecide the extent to which it applies these categorisations in its internaloperational risk measurement system.
• A bank's internal loss data must be comprehensive in that it captures allmaterial activities and exposures from all appropriate sub-systems andgeographic locations. A bank must be able to justify that any excludedactivities or exposures, both individually and in combination, would nothave a material impact on the overall risk estimates. A bank must have anappropriate de minimis gross loss threshold for internal loss data collection,for example Rs.10,000. The appropriate threshold may vary somewhatbetween banks, and within a bank across business lines and/or eventtypes. However, particular thresholds should be broadly consistent withthose used by peer banks.
• Aside from information on gross loss amounts, a bank should collectinformation about the date of the event, any recoveries of gross lossamounts, as well as some descriptive information about the drivers orcauses of the loss event. The level of detail of any descriptive informationshould be commensurate with the size of the gross loss amount.
• A bank must develop specific criteria for assigning loss data arising from anevent in a centralised function (e.g. an information technology department)or an activity that spans more than one business line, as well as fromrelated events over time.
• Operational risk losses that are related to credit risk and have historicallybeen included in banks’ credit risk databases (e.g. collateral managementfailures) will continue to be treated as credit risk for the purposes ofcalculating minimum regulatory capital under this Framework. Therefore,such losses will not be subject to the operational risk capital charge (Thisapplies to all banks, including those that may only now be designing theircredit risk and operational risk databases). Nevertheless, for the purposesof internal operational risk management, banks must identify all materialoperational risk losses consistent with the scope of the definition ofoperational risk (as set out in the definition of operational risk and the lossevent types outlined), including those related to credit risk. Such materialoperational risk-related credit risk losses should be flagged separatelywithin a bank’s internal operational risk database. The materiality of theselosses may vary between banks, and within a bank across business linesand/or event types. Materiality thresholds should be broadly consistent withthose used by peer banks.
• Operational risk losses that are related to market risk are treated asoperational risk for the purposes of calculating minimum regulatory capitalunder this Framework and will therefore be subject to the operational riskcapital charge.
External data
28. A bank’s operational risk measurement system must use relevant external
data (either public data and/or pooled industry data), especially when there is
reason to believe that the bank is exposed to infrequent, yet potentially severe,
losses. These external data should include data on actual loss amounts,
information on the scale of business operations where the event occurred,
information on the causes and circumstances of the loss events, or other
information that would help in assessing the relevance of the loss event for other
banks. A bank must have a systematic process for determining the situations for
which external data must be used and the methodologies used to incorporate the
data (e.g. scaling, qualitative adjustments, or informing the development of
improved scenario analysis). The conditions and practices for external data use
must be regularly reviewed, documented, and subject to periodic independent
review.
Scenario analysis
29. A bank must use scenario analysis of expert opinion in conjunction with
external data to evaluate its exposure to high-severity events. This approach
draws on the knowledge of experienced business managers and risk
management experts to derive reasoned assessments of plausible severe losses.
For instance, these expert assessments could be expressed as parameters of an
assumed statistical loss distribution. In addition, scenario analysis should be used
to assess the impact of deviations from the correlation assumptions embedded in
the bank’s operational risk measurement framework, in particular, to evaluate
potential losses arising from multiple simultaneous operational risk loss events.
Over time, such assessments need to be validated and re-assessed through
comparison to actual loss experience to ensure their reasonableness.
Business environment and internal control factors
30. In addition to using loss data, whether actual or scenario-based, a bank’s firm-
wide risk assessment methodology must capture key business environment and
internal control factors that can change its operational risk profile. These factors
will make a bank’s risk assessments more forward-looking, more directly reflect
the quality of the bank’s control and operating environments, help align capital
assessments with risk management objectives, and recognise both improvements
and deterioration in operational risk profiles in a more immediate fashion. To
qualify for regulatory capital purposes, the use of these factors in a bank’s risk
measurement framework must meet the following standards:
• The choice of each factor needs to be justified as a meaningful driver ofrisk, based on experience and involving the expert judgment of the affectedbusiness areas. Whenever possible, the factors should be translatable intoquantitative measures that lend themselves to verification.
• The sensitivity of a bank’s risk estimates to changes in the factors and therelative weighting of the various factors need to be well reasoned. Inaddition to capturing changes in risk due to improvements in risk controls,the framework must also capture potential increases in risk due to greatercomplexity of activities or increased business volume.
• The framework and each instance of its application, including thesupporting rationale for any adjustments to empirical estimates, must bedocumented and subject to independent review within the bank and bysupervisors.
• Over time, the process and the outcomes need to be validated throughcomparison to actual internal loss experience, relevant external data, andappropriate adjustments made.
(iv) Risk mitigation
31. Under the AMA, a bank will be allowed to recognise the risk mitigating impact
of insurance in the measures of operational risk used for regulatory minimum
capital requirements. The recognition of insurance mitigation will be limited to 20%
of the total operational risk capital charge calculated under the AMA.
32. A bank’s ability to take advantage of such risk mitigation will depend on
compliance with the following criteria:
• The insurance provider has a minimum claims paying ability rating of A (orequivalent).
• The insurance policy must have an initial term of no less than one year. Forpolicies with a residual term of less than one year, the bank must makeappropriate haircuts reflecting the declining residual term of the policy, upto a full 100% haircut for policies with a residual term of 90 days or less.
• The insurance policy has a minimum notice period for cancellation of 90days.
• The insurance policy has no exclusions or limitations triggered bysupervisory actions or, in the case of a failed bank, that preclude the bank,receiver or liquidator from recovering for damages suffered or expensesincurred by the bank, except in respect of events occurring after theinitiation of receivership or liquidation proceedings in respect of the bank,provided that the insurance policy may exclude any fine, penalty, orpunitive damages resulting from supervisory actions.
• The risk mitigation calculations must reflect the bank’s insurance coveragein a manner that is transparent in its relationship to, and consistent with, theactual likelihood and impact of loss used in the bank’s overall determinationof its operational risk capital.
• The insurance is provided by a third-party entity. In the case of insurancethrough captives and affiliates, the exposure has to be laid off to anindependent third-party entity, for example through re-insurance, thatmeets the eligibility criteria.
• The framework for recognising insurance is well reasoned anddocumented.
• The bank discloses a description of its use of insurance for the purpose ofmitigating operational risk.
33. A bank’s methodology for recognising insurance under the AMA also needs to
capture the following elements through appropriate discounts or haircuts in the
amount of insurance recognition:
• The residual term of a policy, where less than one year, as noted above;
• A policy’s cancellation terms, where less than one year; and
• The uncertainty of payment as well as mismatches in coverage ofinsurance policies.
Partial use
34. A bank will be permitted to use an AMA for some parts of its operations and
the Basic Indicator Approach or Standardised Approach for the balance (partial
use), provided that the following conditions are met:
• All operational risks of the bank’s global, consolidated operations arecaptured;
• All of the bank’s operations that are covered by the AMA meet thequalitative criteria for using an AMA, while those parts of its operations thatare using one of the simpler approaches meet the qualifying criteria for thatapproach;
• On the date of implementation of an AMA, a significant part of the bank’soperational risks are captured by the AMA; and
• The bank provides its supervisor with a plan specifying the timetable towhich it intends to roll out the AMA across all but an immaterial part of itsoperations. The plan should be driven by the practicality and feasibility ofmoving to the AMA over time, and not for other reasons.
35. Subject to the approval of its supervisor, a bank opting for partial use may
determine which parts of its operations will use an AMA on the basis of business
line, legal structure, geography, or other internally determined basis.
36. Subject to the approval of its supervisor, where a bank intends to implement
an approach other than the AMA on a global, consolidated basis and it does not
meet the third and/or fourth conditions in paragraph 34 above, the bank may, in
limited circumstances:
• Implement an AMA on a permanent partial basis; and
• Include in its global, consolidated operational risk capitalrequirements the results of an AMA calculation at a subsidiarywhere the AMA has been approved by the relevant hostsupervisor and is acceptable to the bank’s home supervisor.
37. Approvals of the nature described in paragraph 36 above should be granted
only on an exceptional basis. Such exceptional approvals should generally be
limited to circumstances where a bank is prevented from meeting these conditions
due to implementation decisions of supervisors of the bank’s subsidiary
operations in foreign jurisdictions.
BIBILOGRAPHY
1. Basel Committee on Banking Supervision, Sound Practices for theManagement and Supervision of Operational Risk, February 2003.
2. Basel Committee on Banking Supervision, International Convergence ofCapital Measurement and Capital Standards – A Revised Framework, June2004.
3. Basel Committee on Banking Supervision, Framework for Internal ControlSystems in Banking Organisations, September 1998